What is a Put Option?

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Options are the contracts which give the buyer the “right” to buy or sell a financial instrument at a specified time in the future, at a predetermined price. It is to be noted that the buyer has the right, and not the obligation, to exercise the option. So, he may or may not choose to exercise it, depending upon the price of the security in the future.

On the other hand, the seller or the writer of an options contract has the “obligation” to buy or sell the financial instrument, in case the buyer wishes to exercise his option. Options are derivatives as their price is dependent on the price of the underlying asset.

The Put Option is mostly exercised when you are bearish towards the market and believe a particular stock or index is going to be value down.

They add a lot of flexibility to the portfolio as they benefit both the buyer and seller in hedging, speculation, income generation and tax management (more on this later).

Options contract can either be a call option or a put option.

Put Option – Basics

Put Option is an options contract wherein the buyer has the right to sell the underlying financial instruments at a specified price during a specified time in the future. It is like an insurance policy where the owner of the security insures himself against any heavy downtrends in the market by fixing his sale price at a predetermined position.

The specified price is called the strike price and the specified time is the expiration date of the contract. If the price of the security falls below the strike price before the expiration date, the buyer exercises his option and sells the security at the strike price thus saving himself from the loss of selling at the lower current market price.

However, if the price of the security remains the same or increases, he can choose to not exercise the option and earn a profit by selling the stocks in the secondary market at a higher price, obviously.

There is a premium or fee attached to entering into a put option contract, like any other contract. So, the only loss will be the premium paid to the option contract writer.

In other words, the buyer saves him/her self from buying the whole lot of shares and just lose on the premium paid as part of the contract.

Put Option – Example

To state an example, let’s say that a trader thinks that the stock of Tata Motors is overpriced right now at ₹190 per share, so it will soon consolidate or crash down. He is also aware that the company is soon going to release its earnings report which is expected to be not so positive.

In this case, the best option the trader has is to buy the put option on the stock of Tata Motors at a lower exercise price of ₹185 (strike price), with a premium of ₹5 per share.

Now, when the earnings report is released soon, the share price tumbles down to ₹170. The buyer of a put option has the right to still sell the shares of IBM at ₹185 thus giving him a profit of ₹15 per share minus the premium of ₹5, which is ₹10 per share.

If the trader bought that put option for 100 such shares, then the profit would be in the range of ₹1000,

This is a sure-shot profit scenario when the buyer of the put option is sure that the prices are going to go down.

In another case, it is also possible that instead of going down the price went up to ₹195. In that case, the buyer has the right to not exercise his option and the only loss he makes is of the premium that he paid of ₹5 per share. Thus, profits are unlimited, but the losses are only limited to the options contract fee paid (or we call it the premium).

Again assuming he bought the right for 100 such shares, then the total loss would be ₹500.  

The writer or seller of the put option, in this scenario, will earn the premium fee as the option was not exercised.

Put Option – Trading Purpose

Just like call options, put options are also used for speculation, income generation and tax management.

Speculation: Put option is used extensively when the traders are definitely expecting a decline in the market. Using put option, they limit their losses and make huge profits instead.

Income Generation: This is mostly used by the writers of the put option. Instead of just holding the security, they sell a put option on the security, hoping that the option will not get exercised and they will earn the premium.

Tax Management: Put Option is an excellent way to manage taxes. For instance, a person who holds certain shares and knows that the prices are going to decline, he might as well sell the stock and buy later at the lower prices; but by doing so, he will have to pay huge taxes on the capital gain from the sale of the stock. Instead, by using the put option, he is only going to end up paying taxes only on that put option trade.

Thus, put option is a good mechanism to make money and to limit losses, especially in the scenario when the traders are expecting the market to go down.

Put Option – Parting Words

Before we end this review on Put Option, this needs to be clearly understood about the concept:

  • One who is buying the put option has a bearish perspective towards the asset or stock in question while the trader who is selling the right to exercise is either bullish or neutral towards it. He/she is definitely NOT looking at a bearish future trend.
  • The buyer of the put option gets the RIGHT to sell the asset or stock at the pre-decided price (or the strike price) once the expiration date is met. He may choose to exercise the right or not as per his/her choice.
  • The seller of the put option is OBLIGATED to buy the asset or stock at the strike price if the buyer wants to sell it. There is no other option.

Hope we were able to make it clear for you. Let us know in the comments section below in case you have any doubts whatsoever. We will try to clear those for you.

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